Make Room for Storage Stocks

Long term, EMC and Network Appliance will benefit from several trends in the industry.
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The choppy trading of recent weeks may have opened up some buying opportunities for value-oriented investors looking at the shares of data-storage device makers.

Shares of

EMC

(EMC)

and

Network Appliance

(NTAP) - Get Report

have suffered from fears of slower corporate spending on tech equipment. But these fears might be overblown, and the current volatility should subside once spending by businesses and consumers firms up.

These stocks should also benefit from long-term increases in data-storage needs as corporations and consumers push more video onto the Web and companies seek ways to secure and manage data in compliance with regulatory mandates such as Sarbanes-Oxley.

"Everybody is reacting to weak enterprise demand and spending in the near term," says Jawahar Hingorani, an analyst with Standard & Poor's. "But all indications are calling for increasing demand over the long term, especially if you look at peripherals devices and software that go into storage."

When it comes to talking about storage, hardware often gets all of the attention. But software merits as much, because it prioritizes data and helps companies manage access to stored information.

During the last earnings conference call, Network Appliance's Chief Executive Dan Warmenhoven said the company is seeing software subscriptions grow and become a larger portion of total revenue.

Software subscriptions can "embed the company with customers for years" and provide recurring revenue to boost cash flow, he said.

Across the industry, data-storage sales have turned south as companies put off purchases. Network Appliance said its backlog suffered in the last quarter because it took more time to close deals, a symptom of slower tech spending.

But Paul Davis, portfolio manager of the Charles Schwab Technology Fund, said that Network Appliance has held down expense growth and scaled back its aggressive hiring, which will help it weather fluctuations in demand.

He also takes heart in the company's use of cash on hand to repurchase shares, which indicates that management "feels that the stock is oversold."

Network Appliance remains an attractive buy because the stock is greatly outperforming its peers. According to Goldman Sachs, the company's storage revenue grew 34% year over year in the first quarter, vs. 7% for EMC, 5% for

Hewlett-Packard

(HPQ) - Get Report

and 9% for the industry as a whole.

"We continue to be positive on the storage space and see EMC and Network Appliance as prime beneficiaries of the trend toward networked storage," said Vasu Kasibhotla, an investment analyst with Trilogy Global Advisors, which is EMC's largest holder of shares.

Attaching storage devices to a network -- rather than embedding them in servers -- relieves stress on servers and maintains data availability if servers fall. Companies may also prefer to work with EMC and Network Appliance over legacy players such as

IBM

(IBM) - Get Report

and Hewlett-Packard, which have a vested interest in selling traditional server-based solutions.

And Network Appliance's technology edge can serve as a bulwark against competition from networking companies, such as

Cisco Systems

(CSCO) - Get Report

and

Brocade Communications

(BRCD)

, which are looking to capitalize on the trend toward network-attached storage.

"With the recent pullback in Network Appliance's sharing in the last few weeks, it's looking a lot more attractive," said Kasibhotla.

On Friday, Network Appliance added 68 cents, or 2.2%, to $31.89. But it is in negative territory year-to-date.

EMC was one of the most heavily traded stocks Friday. Shares rose 34 cents, or 2%, to $17.35, a sizeable gain for a company with a nearly $36 billion market cap.

EMC shares have risen about 20% year-to-date, in part because it plans to sell a 10% stake in "virtualization" business,

VMware

. Virtualization is software that lets servers run more efficiently.

Goldman Sachs analyst Laura Conigliaro says that VMware's upcoming initial public offering will give EMC's margins room to expand. She feels the stock will be worth 18 times forecasted 2007 earnings, above the 15-times multiple it trades at now.

Goldman has done investment banking work for EMC in the past 12 months.

Despite EMC's recent price appreciation, Trilogy's Kasibhotla says the company's product cycle and VMware spinoff leave additional room for "upside from here."